Our Fundamental View on the Dollar Has Not Changed

The U.S. dollar has rallied quite a bit since April 16—rising by slightly more than 4% through May 141—in seeming contrast with our recent blog (from March 6) arguing that it would continue to weaken. Yet our fundamental view on the dollar, as articulated in that blog, has not changed.

Why We Still Believe The Dollar May Weaken Over the Longer Term
First, to put this rally in context, the U.S. Dollar Index (DXY)2 started the year at 92.24 and is currently (as of May 14) at 93.18, having returned a bit less than 1% as of May 14. In other words, the dollar’s move against a basket of developed-economy currencies has been small on a year-to-date basis.

Yet despite its recent rally, we still believe we could see a weaker dollar over the next two to three years, for the following reasons:

Capital typically flows to countries in which economic growth and returns on investments are higher. As growth leadership shifts abroad, we expect the U.S. dollar to depreciate.

The U.S. dollar is coming off of high valuations and typically swings from expensive to inexpensive. This process historically takes anywhere between 5 to 10 years to complete. Our research suggests that the current cycle is at its mid-point—and that the dollar is not inexpensive yet.

The United States is expected to post large current-account and fiscal deficits over the next two to three years. That means the United States has a savings shortage, and its deficit is funded by foreign savings. Given the recent passage of federal tax cuts, coupled with increased spending by the U.S. government, the Bloomberg consensus for the U.S. federal deficit is estimated at approximately 5% of gross domestic product (GDP), and the current-account deficit consensus is estimated at more than 2% for the next two years. Our expectation is that these twin deficits will be larger than the current consensus—twin deficits can remain at high levels for a while but not forever. At some point, to correct the imbalance, the U.S. savings rate needs to rise or the U.S. dollar needs to depreciate. Historically, the dollar has begun to adjust and weaken when the twin deficits were in the range of 6%– 8% (Exhibit 1).

Going forward, we see global growth continuing to be strong in the rest of the world. Consumer and business confidence on a worldwide basis remain at cyclically high levels. European growth has stabilized after accelerating for a number of quarters, but in our view it remains significantly above its potential rate. Similarly, Japan has grown for eight consecutive quarters—and emerging markets such as India have continued to deliver strong growth. Inflation has also been tame in emerging markets, many of which currently maintain high real yields, somewhat accommodative monetary policies, and improved external balances after facing outflows in 2013.

Why Has the Dollar Rallied?

In recent months, the United States has been forecast to exhibit a somewhat stronger relative growth rate compared with the rest of the world, but we believe such a shift would be a temporary adjustment rather than a new trend. The enactment of the Tax Cuts and Jobs Act of 2017 and Bipartisan Budget Act of 2018 provided additional fiscal stimulus and will likely result in a temporary boost to U.S. growth—the main reason for the shift in forecasts. The momentum in U.S. economic data has also been strong, with first-quarter GDP increasing by 2.3% and beating the expectation of 2%. Recent inflation data such as the annual change in the price index for personal consumption expenditures (the U.S. Federal Reserve’s, or Fed’s, preferred measure for inflation) finally hit the Fed’s target of two percent. The latest rate of inflation was in line with expectations, and we expect it to remain at target levels thanks to faster growth in the U.S. economy, which is close to full capacity.

Meanwhile, economic data in other parts of the world—especially in Europe—has disappointed (see Exhibit 2). We believe that observed weakness in major economies can be explained by temporary factors. Quarterly GDP data tend to be quite volatile and deviations from the trend can occur: Recall the number of weak first quarter U.S. GDP figures in recent years. It is noteworthy to observe that while global data have surprised negatively in recent weeks, U.S. data have surprised positively. The gap between the two is at high levels, and typically, at such high levels, it tends to revert to the mean.

These short-term developments that were unexpected might also have led to a so-called “positioning squeeze”: Speculative short sellers of the U.S. dollar could have been caught off guard given data surprises here and abroad. Typically it takes a while for their positons to be squared, but eventually longer-term trends tend to prevail.

We Are Sticking to Our Medium-Term Call for a Weaker Dollar

Admittedly, there is no perfect exchange-rate model and no economic or market indicators that are reliably correlated with the dollar. But we believe that multiple factors—an improving global economy, capital flows returning to emerging markets, the changing monetary policy stance of global central banks, and the twin deficits in the United States—all support our expectation of a weaker U.S. dollar over the medium term. As we noted in our previous blog, the path toward a weaker dollar need not be a straight line. If U.S. growth and inflation surprise on the upside, as recent data have shown, the dollar may continue to appreciate for a short period.

As active managers, we always carefully monitor short-term developments, but we believe the factors we have outlined above will likely support our call in the medium-term. We firmly believe in our macro-economic analysis and have allocated our risk budget to areas in which we see the highest potential for returns. Short-term volatility can be disconcerting, but our investment process and philosophy have not changed. We continue to view the current economic environment as benign and characterized by plateauing but strong, above-average growth.

^The U.S. Dollar Index (USDX, DXY, DX) is an index (or measure) of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners' currencies. The Index goes up when the U.S. dollar gains "strength" (value) when compared to other currencies.

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